Do exchange-traded funds (ETFs) pose systemic risk? Or are such concerns exaggerated?
It’s been more than 10 years since the outbreak of the global financial crisis, and the bull market (the longest ever) is in late-cycle territory. This combination of concern over the next downturn – what could set it off, spread it, or push it into severe crisis – and massive inflows into ETFs has led some, Moody’s Investors Service and famed hedge fund manager Michael Burry among them, to sound the alarm.
CFA Institute recently convened an ETF expert panel in New York City, and we here examine perspectives raised.
‘Yet to be tested’ during volatility
Jayesh Bhansali, CFA, of the Gabelli School of Business at Fordham University, opened by describing the ETF landscape: “ETFs have grown substantially in size, diversity, scope, complexity and market significance in recent years. Even though they still account for a relatively small portion of the total market cap, about 10% to 12% I recall based on a study, however, the average trading volume is north of 30%.
“While most ETFs track liquid equity indexes, one of their key features is related to the capacity to also replicate baskets of less liquid assets and form more liquid tradable surrogates. But as we all know, this so-called magical liquidity transformation has a tremendous friction cost attached.”
He went on to quote from a Moody’s report: “‘The ETF market has grown rapidly during a period of relative calm, meaning that it has yet to be tested by a period of high market distress or volatility. Unexpected market liquidity shortfalls could be most pronounced with an ETF tracking inherently less liquid markets such as high-yield credit.’”
“The report further adds, ‘These ETF-specific risks, when coupled with an exogenous system-wide shock, could, in turn, amplify systemic risk.’”
What is – and isn’t – an ETF?
To understand their risks, we have to understand what ETFs are. Investment funds composed of systematically selected securities that trade on exchanges doesn’t really describe the ETF universe.
“Where people get confused sometimes is when they think of ETFs as an asset class,” said Samantha Merwin, CFA, of BlackRock. “ETFs are not an asset class. ETFs are an investment wrapper. They’re a tool that allows investors to access the underlying asset classes.”
But there remains uncertainty and some have advocated assigning the ETF label to potentially questionable products.
“There isn’t a good classification around what an ETF is and how it sits in the marketplace,” said legendary ETF market maker Reggie Browne of GTS. “I think that’s a weakness that needs to be addressed. You have folks out there advocating for bitcoin, diamonds, and other esoteric asset classes that don’t belong in the ETF industry.”
Under the microscope
So what role could ETFs potentially play in market downturns?
Ayan Bhattacharya, PhD, of Baruch College, City University of New York, who co-authored the just released CFA Institute Research Foundation title ETFs and Systemic Risks with Maureen O’Hara, PhD, of Cornell University, shared his perspective.
“ETFs are great things,” Bhattacharya said. “Asset pricing theories would say that investors should hold fully diversified portfolios. That’s in theory. But in practice, retail investors, other investors, can’t do that because most of the market is not accessible, assets are too costly, and so on. So ETFs have helped to solve some of those problems.”
But he did highlight some ETF-related concerns. He spoke particularly about ETFs’ heightening effect on market movements, a phenomenon documented by research.
While most panellists acknowledged that ETFs were hardly risk free, they questioned Bhattacharya’s suggestion that ETFs had an especially distinct risk profile or an amplification effect. Since liquidity risk is an issue for all kinds of securities, participants did not see that as ETF-specific. In fact, they found such concerns were much less pronounced for ETFs than for other products.
“With so much attention on the risk of the ETF structure, it’s surprising to me that many investors and advisers overlook most related risks with mutual funds,” said John Penney, CFA, a senior advisor consultant at Invesco. “ETFs can, in fact, alleviate some friction that mutual funds may experience during periods of volatility and heavy selling.”
Indeed, some panellists suggested the visibility that ETFs provide means that they are under more of a microscope. Less transparent securities that may have greater systemic risk potential receive less scrutiny.
‘Know what you own’
Whatever their perspective on the potential systemic risk implications of ETFs, all panellists underlined the importance of education. And much of that came down to what Stephanie M. Pierce of BNY Mellon Investment Management referred to as ‘know what you own’.
“‘Know what you own’ is a concept we educate many clients on,” added State Street’s Ahmuty. “We focus a lot of resources toward educating people on ETF mechanics, the importance of liquidity, and how it all impacts total cost of ETF ownership. What we find is that actually lots of people need help understanding what they own, even sophisticated investors.”
ETFs are relatively new and are evolving. As their use cases expand, so too will their potential risks. So the more knowledge there is, the better.
“I consider myself almost a 20-year ETF novice,” said Steve Oh of NASDAQ. “Our industry is growing rapidly. Even the experts in this room have to keep up with what’s going on.”
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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